Investment Advice from the FOMC

Please note that this file contains interactive charts and graphs so please download the html file rather than reviewing the github .md file.

Abstract

The purpose of this final project (data - A1/A2) is to fulfill the requirements for Modern Data Structures (QMSS G5072). The goal of this project is to obtain economic data from the Federal Reserve System and Yahoo Finance. This summary file explains the theoretical motivation behind this data collection (sections 1-2 below). Throughout this file, there are references to R script files that include web scraping and API R code used to obtain the data used to explore the relationship between the target federal funds rate, volatility, and U.S. 10-year treasury yields (section 4 below). Parts of this code were converted to functions and compiled into an R package (section 3 below).

1 Introduction

The Federal Reserve (“FED”) is the central bank of the United States. The Federal Open Market Committee (FOMC) is responsible for implementing monetary policy by adjusting the discount rate, reserve requirements, and open market operations (Federal Reserve Bank of Saint Louis). The FOMC has eight regularly scheduled meetings each year to determine the future path of monetary policy. The FOMC may also add meetings in times of economic stress or crisis. Before 1995, the FOMC did not announce the results (future stance of monetary policy) of each meeting. However, in February of 1994, the FOMC released its first statement explaining the results of the meeting. In February 1995, the FOMC decided that all changes to the monetary policy stance would be announced after every meeting. Until May 1999, the FOMC only released a statement when there was a change to monetary policy. Thereafter, the FOMC began releasing a statement after every meeting, detailing the current and future stance of the economy and monetary policy, irrespective of whether a change to the current monetary policy stance was made (Federal Reserve Bank of Dallas). Each policy statement details the current conditions and expectations for the economy as well as the current and future path of monetary policy, e.g. the discount rate, open market operations, and federal funds rate.

Specifically, the FOMC changes the target federal funds rate in conjunction with other adjustments to the discount rate and/or open market operations to influence the effective federal funds rate. It was not until July 1995 that the FOMC statements made reference to a specific federal funds rate level. However, in May 1999, the FOMC began referring to the “target” federal funds rate to increase transparency. Although the target rate is set by the FED, the effective federal funds rate is the final rate at which financial institutions lend to each other. The effective federal funds rate is the rate that influences all interest rates as it typically acts as a floor since financial institutions do not have incentives to offer lower rates as they would incur losses. Therefore, the effective federal funds rate is the rate that is set by the market and influenced by the FOMC when it sets the target federal funds rate, discount rate, and open market operations.

Each scheduled FOMC meeting spans two days. Typically, the FOMC policy statement is released on day two at 2 PM EDT. Although the market typically factors in future changes to monetary policy, given the FED’s commitment to transparency, there is a noticeable market reaction when the FOMC policy statement is released. This study will examine how the FOMC’s decision, regarding the target federal funds rate, affects volatility and treasury yields.

2 Data & Methodology

In order to study the relationship between FOMC policy statements, target federal funds rate, volatility, and treasury yields, data will be scraped from the FED’s website and Yahoo Finance using a FRED API key.

Note: All data were obtained as of December 1, 2017.

2.1 Time Period

Although the FED has archived and made available all FOMC meeting materials since 1936, all data for this study will begin in 1995, which is when the FOMC started releasing statements at the conclusion of certain meetings. For the FOMC meetings from 1995 - 1999, when no change to the current monetary policy stance was made, thus no policy statement issued, the hypothesis is that the market should have reacted to the absence of a statement which signaled no change to monetary policy.

2.2 FOMC Policy Statements

The date that the FOMC policy statement was released or will be released in 2018 will be scraped from the FED’s website. Statements released before 2011 have been archived, whereas statements released since 2012 have not yet been archived and are available in a different location of the FED’s website. Therefore, the web scraping techniques used to scrape the date of each statement will differ based on its website location. Please refer to the FOMC Policy Statements.R file for this code.

2.3 Target Federal Funds Rate

Changes to the target federal funds rate are implemented the day after the FOMC policy statement is released (Board of Governors of the Federal Reserve System). Therefore, the target rate/range data on the day after each meeting will be used which represents the outcome of the meeting by which the market should react to upon the FOMC policy statement release on day two (the conclusion) of the meeting.

The daily target federal funds rate data are only available from September 27, 1982 to December 15, 2008, while the upper and lower limits of the target federal funds rate data are available from December 16, 2008 to present. Therefore, both sets of data will be pulled from FRED using a FRED API key. Please refer to the Target Rates.R file for this code. Once the data are obtained, the difference between the current rate/limits and previous rate/limits will be calculated i.e., the target rate/limits on the day after the conclusion of the FOMC meeting will be subtracted from that of the previous meeting. Changes in the target federal funds rate will be compared to changes in volatility and treasury yields. Please refer to the VIX_treasury_fedfunds_meetings_diff.R file for this code.

The Research Division of the Federal Reserve Bank of Saint Louis developed FRED. FRED is a database that offers regional and national financial and economic data and information to enhance economic research. FRED is constantly updated and accessible at all times. The FRED API allows users to retrieve economic data from FRED. API requests can be tailored to retrieve data source, release, category, series, and more. The FRED API documentation is available on FRED’s website.

2.4 Volatility

Changes to the target federal funds rate/limits will be compared to changes in volatility (adjusted close minus open price* on the day the FOMC policy statement is released) to analyze the market’s reaction to the FOMC’s announcement made in the FOMC policy statement. This look-back analysis will explore whether a relationship exists between FOMC announcements about the target federal funds rate and volatility. Please refer to the VIX_treasury_fedfunds_meetings_diff.R file for this code.

* Intraday data are not available free of charge, therefore, open and close data must be used instead. The assumption is that the open price reflects market conditions before the FOMC announcement whereas the close price reflects market conditions as a result of the FOMC announcement.

Daily volatility data will be represented by the Chicago Board Options Exchange Volatility Index (“VIX”). These data will be obtained from Yahoo Finance. Please refer to the VIX.R file for this code.

2.5 Treasury Bills

Daily 10-year treasury note data will be obtained from Yahoo Finance. Please refer to the Treasury.R file for this code.

Changes (adjusted close minus open price* on the day the FOMC policy statement is released) in the 10-year treasury yield will be analyzed in relation to changes in the VIX. The hypothesis is that when volatility increases, on an FOMC meeting day, the quantity demanded for 10-year treasury bills will increase, driving price up. Inversely, when volatility decreases, on FOMC meeting days, the quantity demanded for 10-year treasury bills will decrease, driving the price down. Please refer to the VIX_treasury_fedfunds_meetings_diff.R file for this code.

* Intraday data are not available, therefore, open and close data must be used instead. The assumption is that the open price reflects market conditions before the FOMC announcement whereas the close price reflects market conditions as a result of the FOMC announcement.

3 R Script and Package Methodology

The following chronological steps include the R code used create my R package.

1. Create package called EconFiData. This package allows users to gather economic and financial data from the Federal Reserve and Yahoo Finance.

library(roxygen2)
library(devtools)

## Loading required package: usethis

library(testthat)

## 
## Attaching package: 'testthat'

## The following object is masked from 'package:devtools':
## 
##     setup

path <- "/Users/StephanieLangeland/Desktop/Columbia/Modern Data Structures/Langeland_Stephanie/final project/EconFiData"

devtools::create(path)

setwd(path)

2. Refer to the /final project/EconFiData/R folder for the function files and data files:

devtools::use_data(meeting_dates)
devtools::use_data(Federal_Funds_Target_Rate)
devtools::use_data(vix_data)

3. Set up package dependencies:

usethis::use_package("httr")
usethis::use_package("rvest")
usethis::use_package("jsonlite")
usethis::use_package("RSelenium")
usethis::use_package("XML")

4. Add a README file, which includes information about all files within the package folder:

devtools::use_readme_rmd()

5. Write vignettes:

devtools::use_vignette("get_historical_dates_vignette")
devtools::use_vignette("get_series_obs_vignette")
devtools::use_vignette("all_yf_functions_vignette")

6. Check package:

setwd(path)

library(EconFiData)

check()

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usethis::use_testthat()

7. Install:

setwd("..")
install("EconFiData")

Note: Example data sets are provided within the package. Users can download them and use rbind() to add their data to the existing data sets.

4 Summary Statistics

The final data set includes the following variables:

Variable Name	Variable Description
Date	Date of each observation.
fomc_day_1	Day one of an FOMC meeting.
fomc_day_2	Day two (the conclusion) of an FOMC meeting.
day_after_fomc_day_2	The day after day two (the conclusion) of an FOMC meeting.
vix_open	Daily open value of the VIX.
vix_high	Daily highest value of the VIX.
vix_low	Daily lowest value of the VIX.
vix_close	Daily close value of the VIX.
vix_adjclose	Daily adjusted close value of the VIX.
10_yr_treasury_open	Daily open value of the 10-year treasury note.
10_yr_treasury_high	Daily highest value of the 10-year treasury note.
10_yr_treasury_low	Daily lowest value of the 10-year treasury note.
10_yr_treasury_close	Daily close value of the 10-year treasury note.
10_yr_treasury_adjclose	Daily adjusted close value of the 10-year treasury note.
Target_Fed_Funds_Lower_Limits	Daily lower limit value of the target federal funds rate.
Target_Fed_Funds_Upper_Limits	Daily upper limit value of the target federal funds rate.
Federal_Funds_Target_Rate	Daily value of the target federal funds rate.
Target_Fed_Funds_Lower_Limits_diff	The lower limit value of the target federal funds rate on the day after the conclusion of the FOMC meeting, subtracted from that of the previous meeting.
Target_Fed_Funds_Upper_Limits_diff	The upper limit value of the target federal funds rate on the day after the conclusion of the FOMC meeting, subtracted from that of the previous meeting.
Federal_Funds_Target_Rate_diff	The value of the target federal funds rate on the day after the conclusion of the FOMC meeting, subtracted from that of the previous meeting.
target_rate_change	Depending on the year, the FOMC either mentioned the actual target federal funds rate or the lower and upper limits of the target rate in the policy statement. In order to combine these data into one variable, the Target_Fed_Funds_Upper_Limits_diff and Federal_Funds_Target_Rate_diff variables were combined into this variable. This was possible because the upper and lower limits are always adjusted in equal increments. Thus, it was only necessary to use the upper limit. Also, the Federal_Funds_Target_Rate variable ended on 2008-12-15 while the Target_Fed_Funds_Lower_Limits and Target_Fed_Funds_Upper_Limits began on 2008-12-16 so there is no overlap.
vix_diff	The VIX adjusted close value minus the open value.
10_yr_treasury_diff	The 10-year treasury note adjusted close value minus the open value.
target_rate_change_shift	Changes to the target federal funds rates/limits are made the day after the conclusion of the FOMC meeting. Therefore, these observations are always one row below the row containing data from day two of the FOMC meeting because these dates differ. However, the future path of the target rate is announced at the conclusion of the FOMC meeting on day two, thus that is the day that the market will react. Therefore, the observations for the target_rate_change variable were shifted up one row so that they would be in the same row as day two of each FOMC meeting. This variable was created for data visualization purposes.
target_rate_change_shift_sign	This is the sign of the target_rate_change variable. This variable was created for data visualization purposes.

The following is an interactive chart that displays a subset of the final data set to contextualize the above description of the variables:

4.1 Target Federal Funds Rate

In order to understand the movements of the VIX and 10-year treasury note, as a reaction to the target federal funds rate change announced via the FOMC policy statement, it is important to understand the distribution of the changes made to the target rate. From 1995 - 2017, there were 216 FOMC meetings. The most common rate decision was to leave the target rate unchanged. Whereas there is nearly an even split between increasing and decreasing the rate. The target federal funds rate is not volatile because the FED is committed to keeping it stable, which fosters economic stability. Typically, the FED makes changes to the rate as a response to an economic crisis. Therefore, many of the rate changes noted below may have been responses to the saving and loans, dot com, and housing market bubbles that burst during the study period.

Summary of Target Federal Funds Rate Changes

	Count	Pct	Cum.Pct
Negative Rate Change	28	12.96	12.96
No Rate Change	159	73.61	86.57
Positive Rate Change	29	13.43	100.00
Total	216	100.00	199.53

4.2 Volatility

Working on the premise that the FED usually changes the target rate as a reaction to a crisis or bubble and normalization thereafter, there should still be a market reaction via volatility. When the FED decreases the target rate, this signals accommodative monetary policy, which means that the economy is under stress. Inversely, when the FED increases the rate, the economy should be in a recovery or stable period. However, the rate typically remains flat, per the above table. Since the 2008 Financial Crisis, the FED lowered rates to the zero lower bound and has begun tightening in recent years. Tightening of monetary policy is analogous to increasing the federal funds rate. Though, this is a very gradual process since the FED cannot risk overheating the economy during booms. The following visualization is an interactive graph that shows the relationship between the daily change in the VIX (vix_diff) and target federal funds rate (target_rate_change) decision on day two of the FOMC meeting. Please hover over the VIX values in order to see the date, amount by which the VIX changed, volatility level, and target federal funds rate decision/change.

There does not seem to be a clear pattern between the VIX and target rate. This may be attributed to exogenous factors that are not accounted for here. The next step would be to run a regression analysis to understand how well the changes to the target rate contribute to changes in the VIX. This regression analysis is a recommendation for future research as it is out of scope for this project.

4.3 Treasury Bills

The following visualization is an interactive graph that shows the relationship between the daily change in the 10-year treasury note (10_yr_treasury_diff) and target federal funds rate (target_rate_change) decision on day two of the FOMC meeting. Please hover over the 10-year treasury note values in order to see the date, amount by which the 10-year treasury yield changed, and target federal funds rate decision/change.

According to the flight to quality theory, in times of economic uncertainty or stress, investors typically buy safe haven assets, such as U.S. treasury notes whereas they tend to buy riskier assets during growth periods. This theory supports the demand curve for U.S. treasury notes. However, the FED can only influence the supply curve for treasury notes through open market operations, which puts upward or downward pressure on interest rates. The above graph captures the relationship between the treasury yield and changes in the target rate. However, we cannot discern whether movements in the treasury yield were due to movements in the supply or demand for treasury notes. Similar to the VIX versus target rate, there is no clear relationship between the target rate and treasury yield. However, the VIX may shed more light on the treasury yield noted above if the flight to quality theory holds true. Therefore, the hypothesis supporting the following interactive graph is that when volatility increases, on day two of an FOMC meeting day, investors will purchase treasury notes as safe haven assets, which drives the treasury yield down and the price up. The reverse should be true when volatility decreases. Please hover over the VIX values below in order to see the date, amount by which the VIX changed, volatility level, amount by which the 10-year treasury yield changed, and target federal funds rate decision/change.

The above graph does not always display the expected outcome predicated by the flight to quality theory. Decreases in the treasury yield are not always accompanied by increases in the VIX, which would theoretically result from economic stress. The inverse is also true such that increases in the treasury yield are not always coupled with subdued volatility, which would hypothetically result from economic booms. Therefore, there may be exogenous factors influencing these relationships that are not accounted for above.

5 Conclusion & Future Research

The purpose of this research project was to build an R package and write code that clearly outlines how to obtain economic and financial data from various sources through API calls and web scraping techniques. The data obtained from these methods was then summarized above. The above graphs display the relationships between the VIX and target federal funds rate as well as the treasury yield and target federal funds rate. These graphs do not present clear patterns between these variables, which may be caused by non-linear relationships between the variables. Future researchers may consider conducting a deeper analysis about these relationships by building various regression models that utilize the above variables as well as other variables that may account for exogenous shocks to the models.

6 Works Cited

Board of Governors of the Federal Reserve System. FOMC’s target federal funds rate or range, change (basis points) and level. 14 June 2017. 22 November 2017 https://www.federalreserve.gov/monetarypolicy/openmarket.htm.

Federal Reserve Bank of Dallas. A Short History of FOMC Communication Vol. 8, No. 8, September 2013 . 19 November 2017 https://www.dallasfed.org/research/eclett/2013/el1308.cfm.

Federal Reserve Bank of Saint Louis. How Monetary Policy Works. 19 November 2017 https://www.stlouisfed.org/in-plain-english/how-monetary-policy-works.